Outsourcing Law & Business Journal™ – November 2011
November 14, 2011 by Bierce & Kenerson, P.C.
OUTSOURCING LAW & BUSINESS JOURNAL™ : Strategies and rules for adding value and improving legal and regulation compliance through business process management techniques in strategic alliances, joint ventures, shared services and cost-effective, durable and flexible sourcing of services. www.outsourcing-law.com. Visit our blog at http://blog.outsourcing-law.com.
Insights by Bierce & Kenerson, P.C. Editor. www.biercekenerson.com.
Vol. 11, No. 9, November 2011
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1. To Arbitrate or Not, That is the Question.
2. Humor.
3. Conferences.
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1. To Arbitrate or Not, That is the Question. In KMPG LLP v. Cocchi, the U.S. Supreme Court ruled on November 7, 2011, that agreements to arbitrate must be enforced in federal and state courts under the Federal Arbitration Act, 9 U.S.C. §1 et seq. 565 U.S. ___ (2011). Judicial interpretation of arbitration clauses has resulted in the bifurcation of remedies before courts and arbitrators on the same facts. Such bifurcation adds costs and leads to uncertainty for the parties.
This case serves as a reminder to both parties to consider possible risk management and relationship governance frameworks. This article analyzes some ways to identify and minimize the risk of such bifurcation and piecemeal dispute resolution that neither party wanted. The parties may wish to evaluate and, at least internally, quantify the impact for pricing purposes in contract negotiation.
This decision relates to alleged professional malpractice by a regulated professional service provider. For unregulated BPO “professional” service providers, it raises red flags. It shows the risk profile for claims from persons other than the enterprise customer. The parties therefore may wish to consider the interests of persons who might be adversely affected by the BPO services, such as the BPO service recipient’s own customers, suppliers, users and licensees. Such interests can be addressed in the frameworks of relationship governance, risk management and compliance. For more, click here.
2. Humor.
Arbitration, n. (1) clandestine back-alley street fight, conducted in total confidence to avoid embarrassment, oppressive disclosure and discovery rules and judicial delays; (2) private justice for private failures.
Arbitrary, adj. (1) the outcome of an arbitrable claim; (2) the result of a preponderance of the credible evidence.
Enforce, v. (1) to apply power where shame, remorse, regret, denial, fear and hostility fail to get results.
3. Conferences.
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To Arbitrate or Not, That is the Question
November 14, 2011 by Bierce & Kenerson, P.C.
In KMPG LLP v. Cocchi, the U.S. Supreme Court ruled on November 7, 2011, that agreements to arbitrate must be enforced in federal and state courts under the Federal Arbitration Act, 9 U.S.C. §1 et seq. 565 U.S. ___ (2011). Judicial interpretation of arbitration clauses has resulted in the bifurcation of remedies before courts and arbitrators on the same facts. Such bifurcation adds costs and leads to uncertainty for the parties.
This case serves as a reminder to both parties to consider possible risk management and relationship governance frameworks. This article analyzes some ways to identify and minimize the risk of such bifurcation and piecemeal dispute resolution that neither party wanted. The parties may wish to evaluate and, at least internally, quantify the impact for pricing purposes in contract negotiation.
This decision relates to alleged professional malpractice by a regulated professional service provider. For unregulated BPO “professional” service providers, it raises red flags. It shows the risk profile for claims from persons other than the enterprise customer. The parties therefore may wish to consider the interests of persons who might be adversely affected by the BPO services, such as the BPO service recipient’s own customers, suppliers, users and licensees. Such interests can be addressed in the frameworks of relationship governance, risk management and compliance.
The Parties. This case involved parties claiming that KPMG LLP was liable to them as investors in limited partnership investments that were allegedly defrauded by convicted securities fraud Bernie Madoff. KPMG had audited the financial statements of the investment partnerships. KPMG had included an arbitration clause in the engagement letter that covered all claims from their services, or so it thought.
The Claims. The defrauded investors asserted four different claims against KPMG. Two were common law claims: negligent misrepresentation and professional malpractices. Two arose from statutes intended to protect claimants, but none of those claimants were signatories to the engagement letter: violation of the Florida Deceptive and Unfair Trade Practices Act (FDUPTA) and aiding and abetting a breach of fiduciary duty. All the claims are based on the same alleged facts, that KPMG allegedly failed to use proper auditing standards that proximately led to substantial misrepresentations about the financial condition of the investment funds, resulting in investors’ losses.
“Derivative or Direct?” Whose Claims Are Covered by the Agreement to Arbitrate? The Court reviewed the question whether the arbitration clause could only be enforced if the plaintiffs’ claims were “derivative” (subordinate, arising out of the services that KPMG performed for the investment partnerships that were KPMG’s clients and therefore subject to arbitration). Applying Delaware law, the Court of Appeal for the Fourth Circuit concluded that the claims of negligent misrepresentation and violations of FDUPTA were direct, not derivative, and therefore could be asserted directly by the investors. Unless the claimants have agreed to arbitrate, “direct” claims are not arbitrable. That Court of Appeal affirmed the trial court’s denial of KPMG’s motion to arbitrate.
The Supreme Court concluded that the characterization of claims as derivative or direct is a matter of state law. That was not in dispute.
Limitation on Trial Court Discretion in Deciding Which Claims are Direct (and thus Outside the Arbitration Clause) and Which Are “Derivative.” The Supreme Court revered and remanded that lower court’s decision because the lower courts had rejected KPMG’s motion to compel arbitration of those claims that were covered by the arbitration clause. In short, the lower courts had wrongly decided that, if two of the four claims were NOT arbitrable, then none of the claims were arbitrable. The Supreme Court held that the lower courts failed to follow the plain meaning of the Federal Arbitration Act and a 1985 precedent, Dean Witter Reynolds, Inc. v. Byrd, 470 U.S. 213, 217 (1985), by their failure to “examine a complaint with care to assess whether any individual claims must be arbitrated,” when a complaint contains both arbitrable and non-arbitrable claims. Slip Op., at p. 4.
Lessons for Outsourcing. Outsourcing contracts are very similar to the KPMG audit services agreements. The parties agree to arbitrate all disputes arising out of the agreement. Any “direct” claims by customers or users of the services are independent of the arbitration clause and thus subject to direct litigation in courts.
Value of Arbitration. A well-drafted arbitration clause offers many benefits:
- shield the parties from the publicity of their dispute;
- obtain a neutral decision under well-administered scheduling process;
- escape from the whims and attitudes of a jury that is not sophisticated and generally may consider non-business, maybe non-legal, sentiments rather than what is “commercially reasonable”;
- confidentiality enables some more avenues for negotiated resolution, without judicial supervision of the settlement;
- become enforceable not only in the United States, but in other countries that are parties to arbitral enforcement conventions.
In global sourcing, reputational damage can arise from publicity of a dispute, so the confidentiality has some benefits for each party.
Shared Risk Management. Early “master services agreements” shifted to the service provider the responsibilities for risk management and compliance. Some commentators (such as Kate Vitasek, a professor in University of Tennessee) suggest that a partnership approach can mutually reduce individual and collective costs and liabilities in risk management and compliance. The KPMG v. Ciocchi decision invites providers and recipients of global services to implement effective communications and joint decisions, and to reduce potential liability to third parties. In the KPMG situation, however, the service recipient (managers of limited partnerships as investment funds) had no knowledge of the “professional standards” for auditing, and thus did not really care, or had no incentive, to share, in the risk management issues facing the “professional services provider” (auditors).
Professional Services: GRC Challenges for “Professional Services.” The KPMG decision also reminds licensed professionals such as architects, attorneys, accountants, engineers, auditors and other licensed professionals that “the buck stops here.” As is well settled under the Dean Witter Reynolds decision in 1985, such licensed professionals cannot escape statutory liability (and court litigation) from affected individuals even if their corporate client signs an arbitration agreement. So they need to consider the pricing impact of such potential liability, as well as the costs of defense where they could eventually win against the affected individuals (such as customers, users, licensees, employees of the client enterprise) who allege statutory rights, including potential punitive damages and “racketeering” triple damages.
Enterprise customers have an interest in the viability of their service providers. Clients of Arthur Anderson experienced significant lost time and lost value when Enron collapsed and the accounting firm “disappeared.” For the same reasons, outsourcing customers should respect the rights of service providers to limit liability and to participate in joint risk management and compliance activities. In short, transparency and effective relationship governance offer real value to both sides.
Service Providers. For BPO service providers, the KPMG v. Ciocchi decision is a wake-up call to identify, in due diligence, the risks of litigation with an enterprise customer’s downstream clients, users and customers under the “direct vs. derivative” dichotomy. If such risks exist, then BPO service provider may wish to discuss indemnification issues.
The BPO service provider can therefore raise the question whether it should be indemnified for claims arising from indirect users of those services, such as a bank’s customers, an insurance company’s insured policy holders, or a mortgage origination company’s loan applicants. Such an indemnification would not convert the “direct” claims into “derivative” claims, but would leave the service provider in the position of asserting an indemnification claim against its BPO customer. Assuming its customer is solvent, then the customer has assumed the liability of such “direct” claims, and the courts could then be asked to compel arbitration for all such claims if such BPO customer had obtained arbitration agreements from its own end-users or downstream customers.
Enterprise Customers. For enterprises purchasing BPO services, the KPMG v. Ciocchi decision highlights the need for adopting and implementing their own arbitration dispute methods in contracts with their own clients, users and customers. If the BPO service provider comes to you asking for an indemnification or a higher price, you will get the message. Maybe you can sidestep the issue by simply refusing to indemnify, since the enterprise is not responsible to its clients, users and customers for the wrongdoing of its BPO service provider for “direct” claims that escape arbitration under the Dean Witter decision. Or maybe you would be happy to pay a higher price to escape the indemnification. Or you might reject the BPO service provider as an eligible vendor. These issues can be explored in the “assessment” and “selection” processes.
Impact of KMPG Decision on BPO Governance Models for Dispute Resolution and Relationship Governance. Whatever its negotiating position, the enterprise customer needs to adopt risk management strategies that address its potential vicarious liability that might arise from an insufficient legal structure for relationship governance or a failure to actually track and implement a robust governance process. In short, the enterprise customer has potential vicarious liability to its own customers, clients and users under principles of respondeat superior and negligent supervision. The enterprise customer may mitigate its potential liability by obtaining insurance coverage and indemnification for willful misconduct and gross negligence of the BPO service provider. But respondeat superior and negligent supervision apply to cases where the enterprise customer failed to “manage” and “oversee” the BPO service provider’s ordinary negligence. All this invites further discussion at the planning stage.
Risk Management Practices. Each party needs to identify and address issues that relate to the use of arbitration (or, alternatively, litigation in court) by contract.